Real World Economics: Long-term fiscal solution? That's unlikely

There is much irony in the whole "fiscal cliff" debate in that the greatest danger to the economy lies in reducing the budget deficit too soon and too fast.

That is what Ben Bernanke had in mind when he coined the term. That is what most economists see as the primary issue. It is what concerns Wall Street and CEOs of nonfinancial corporations.

But all of the posturing on the part of the administration and Congress focuses on cutting the deficit. Neither side is asking the question of how much deficit reduction, if any, is appropriate.

Let me interject some personal views at the start.

First, I consider myself something of a deficit hawk. My files hold slides from talks I gave 20 years ago warning that we needed to get our fiscal house in order. I don't think I gave any speeches in the decade since the George W. Bush administration threw away the modest progress made between 1994 and 2000 that did not have the dangers of a structural deficit as a major theme. So please refrain from sending me emails telling me I don't appreciate the gravity of the problem. I was preaching about it when some were applauding the very idiocies that got us into this mess.

Second, I don't think we are going to solve the problem. There will be an "outcome;" and some possible outcomes are better or worse than others. But until the nation becomes less divided politically and economists are able to reach and voice an authoritative consensus, we are going to have a series of short-term, hodge-podge fixes but no long-term solution.

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Divided nations often need deep pain to force consensus and we really haven't felt much pain yet. So my expectations are very low.

Now, let me start by asserting that while not all economists think that both spending cuts and tax increases tend to slow an economy, a strong majority of them do. Critics will reply that this is a tenet of Keynesian economic theory that was accepted wisdom within the discipline decades ago but has since been rejected. And the theories of John Maynard Keynes are overtly rejected by many Republicans. (However, all the Republican presidential candidates since 1988 have had either conservative Keynesians as economic advisers during their campaign or named them to key positions when elected.)

It is certainly true that Keynes believed that such "austerity measures" slow economies. It was key to his argument that government could use varied taxing and spending, coupled with changes in the money supply and interest rates, to speed economic activity in recessions and slow it when unsustainable booms brought inflation.

It is also true that many economists now are skeptical about this prescription. Some, myself included, read history from 1950 to 1975 as evidence that politicians across the political spectrum love to step on the gas pedal of more spending and lower taxes but never want to step on the brake.

Others economists use sophisticated math to argue that when people in a country make rational decisions about how to order their own affairs in the face of Keynesian micromanagement of the economy, the outcome of their collective decisions will be to render such micromanagement futile or even harmful. This group includes some of the best theorists and dominates most of the best graduate programs in the discipline right now.

But proving that deliberate variation of taxing and spending to control the economy does not succeed is not the same as proving that large increases or decreases in them have no effects.

Moreover, modern economic history is full of instances in which cuts in spending, coupled with increases in taxes, threw economies into recession. Most of the countries in the European Union are demonstrating that right now. Almost universally, such austerity programs slow output, lower income and raise unemployment, at least in the short run.

That caveat leads to another reaction. If we need to get revenues in line with spending for our economy to be healthy in the long run and higher taxes with lower spending would do that, some argue, why don't we just plunge ahead and accept the short-term pain of the recession as a cost to be paid? If you have a tumor that may kill you, why not cut it out now? The operation will be painful, but your chances of living will be much higher.

This is an argument that deserves debate. However, the people who make it often seem extremely naive about the length and depth of the recession that might ensue. It would not be a matter of unemployment rising to 9 percent for a few months and then everything being hunky-dory. The cut in spending and increase in taxes that will happen automatically totals about 4 percent of GDP. Closing the entire deficit in one fell swoop would involve adjustments of 7 percent.

History shows that austerity programs of these magnitudes cause major recessions with deep social pain that last years.

Moreover, as Europe is demonstrating, austerity programs usually fail to achieve desired deficit reductions. Recessions cut tax revenue and increase outlays on programs such as unemployment and food stamps. Yes, we could pass new legislation abolishing such programs, but the resulting pain for society would be great.

Some argue that the very fact that Congress and the president were working to reduce long-term deficits would cause such a spike in business and household confidence that any recession would be curtailed.

Again, the argument deserves consideration. Some two decades ago we also seemed mired in intractable deficits. Presidents George H.W. Bush and Bill Clinton had the courage to raise taxes back from the recklessly low levels to which they had been cut in 1988. Supply-siders predicted doom and falling tax revenues from the higher rates, but instead revenue rose sharply and confidence returned strongly. I think this is an underappreciated lesson from the 1990s.

But there were many other factors, including a favorable technology boom, a sharp decline in defense spending after the collapse of communism, and, in the last years of the decade, an increasingly loose monetary policy under the aegis of Fed Chairman Alan Greenspan that would ultimately lead to the bubble that popped in 2006. So don't expect miracles and don't delude yourself that yet another round of tax cuts would be the key. But that is another column.